1. Field of the Invention
The present invention relates generally to systems and methods for trading a trade list in non-displayed markets. In particular, the present invention relates to systems and methods for maintaining constraints, such as dollar or sector neutrality, when trading securities, found in a trade list or portfolio, in alternative trading systems.
2. Description of the Related Art
Generally, in the financial trading industry, there are two types of available destinations for execution of orders to trade securities: “displayed” and “non-displayed.” At a displayed destination, information relating to BUY orders (bids) and to SELL orders (offers) is made available to interested parties. By contrast, BUY and SELL orders sent to non-displayed destinations are not made available to the public, and are instead kept hidden. The lack of disclosure found in non-displayed trading forums provides both benefits and drawbacks, as further discussed below.
The NYSE, NASDAQ, and ECNs are examples of displayed destinations, also called the “open markets.” These destinations publish, by subscription or otherwise, data related to BUY and SELL orders, e.g., “level 2” data available at each trading destination. This published data can be electronically transmitted to subscribers, and be displayed using a graphical user interface in combination with a display device, such as a desktop computer.
Non-displayed destinations are generally known as alternative trading systems or ATSs. Because BUY and SELL order information in ATSs is kept hidden, these trading forums are attractive destinations for traders who desire minimal information leakage about their orders. By minimizing the information leakage, market impact can be minimized, at least, or avoided, at best. Institutional traders often trade large quantities of shares, commonly called “blocks”, and information leakage can result in price movement that may have a dramatic affect on the trader's overall return.
For example, if a trader submitted a BUY order for 100,000 shares of IBM to a displayed destination, information about this BUY order would be available to everyone subscribing to the corresponding market data. Sellers armed with knowledge of the submitted BUY order would be aware of the high demand for IBM and will submit SELL orders for IBM at an increased price. As a result, upward pressure is placed on the IBM stock price. Conversely, if the same BUY order had been submitted at an ATS, the order information would have been hidden, and any risk of upward pressure resulting from the BUY order information would have been alleviated.
ATSs generally differ from displayed markets with respect to trade execution price. In particular, unlike displayed destinations, when a match occurs at an ATS between BUY and SELL orders for the same security, the ATS typically sets an execution price for that match that is derived from current prices displayed in the open markets. In some ATSs, such as ITG's POSIT, the execution price for a match is the midpoint price of the displayed market bid and ask.
Unfortunately, ATSs suffer from some disadvantages because of their hidden or “dark” nature. One disadvantage is that the liquidity available at ATSs is typically smaller than the liquidity available at displayed destinations. However, as described above, the non-displayed liquidity of ATSs is valuable to institutional investors due to the reduced risk of information leakage.
Compounding the smaller liquidity, is the fact that traders cannot see the BUY and SELL orders available in the ATSs. As a result, there is no guarantee of a trader completely or partially filling a BUY or SELL order submitted to an ATS. Thus, the risk of no execution or partial executions always exists when trading in ATSs.
ATSs have the disadvantage that their liquidity is not continuous. That is, the liquidity found at an ATS during one trading period is not necessarily found during any other trading period. Further, the liquidity that exists at an ATS is not necessarily consistent even throughout the trading time period. Moreover, liquidity between ATSs varies, and while one ATS might have high liquidity for a particular stock, a different ATS might simultaneously have low liquidity for the same stock.
Some ATSs have minimum size requirements that restrict when an order can be submitted to the ATS. The bigger the minimum size limitation, the larger the dollar commitment to that ATS becomes. Thus, a trader that wants to trade at a particular ATS that has a high minimum size requirement may be forced to concentrate their trade orders at that one ATS, rather than a variety of ATSs having smaller minimum size requirements or no size requirements.
It is not possible for a trader to force the execution of an order at an ATS if the liquidity is simply not present. Trying to force an execution (by crossing the bid-ask spread) is a capability in the open markets that causes information leakage.
Many investment managers maintain portfolios that are both long and short (i.e., different securities are bought and sold in the same portfolio). The purpose of such a strategy is to hedge market risk and capture relative stock specific returns. In order to keep these types of portfolios fairly risk neutral, it is important to trade them at a specified rate, consistent with the overall composition of the portfolio. Typically, this rate is 1:1, which means SELLs and BUYs should be executing at the same rate dollar wise (i.e., “dollar neutrality”). When SELLs and BUYs execute at the same rate, the trading is dollar neutral. However, there may be times when a trader desires a different rate of execution.
Dollar neutrality during trading is also important to managers of portfolios that contain only long positions (i.e., long-only portfolios). When long-only portfolios are rebalanced, the resulting trade lists are typically a mixture of BUY and SELL trades, containing stocks the trader wishes to increase and decrease positions in. Maintaining dollar neutrality throughout the duration of trading helps reduce a portfolio or trade list's exposure to stock price volatility. As prices generally rise, unfilled BUY orders will become more expensive to execute, while unfilled SELL orders will be more valuable. Thus, value lost on one side of the trade list is hedged by the change in value of the list's other side.
Dollar neutrality is difficult to achieve when trading in ATSs for at least the above-described reasons. One way to control dollar neutrality, and other properties of a trade list, while trading in one or more ATSs is to submit a limited number of small orders to the various ATSs. The orders can be sized in such a way that when filled, the list's properties, for example dollar neutrality, are maintained. However, this technique limits the exposure of the trader's orders to the hidden liquidity available at the ATSs. Therefore, this technique is undesirable because it forces a trader to sacrifice possible executions in order to maintain a trade list's neutral characteristics.
Similar to dollar neutrality is the concept of “sector neutrality.” In the case of sector neutrality, a trader desires to maintain dollar neutrality, as described above, on a sector level. In other words, if the list is broken down into many sub-lists—one list for each sector—then sector neutrality is equivalent to applying dollar neutrality at the sub-list level. Sectors maybe broken down by industry, for example agricultural or automotive.
For displayed destinations, i.e., open markets, algorithms exist for taking a long-short portfolio, and ensuring that the execution rate between the BUYs and SELLs are within a specified tolerance. This is easy because the markets are displayed. If one side, either BUY or SELL, of the portfolio happens to be over executing, algorithms can adjust the rate of execution by canceling out trades on the side that is over executing. Furthermore, these algorithms have the ability to cross the bid-ask spread for the side that is executing too slowly, virtually ensuring an execution for that side.
Additionally, in a displayed destination, a trader may utilize market orders that will continually consume liquidity until the client order is filled. This is possible because, in a displayed destination, current market pricing and liquidity is visible. However, when trading at ATSs, it may be difficult to determine if a counter party exists for a trade, and because the liquidity at an ATS remains hidden there can be no guarantee of an execution. Furthermore, most ATSs will automatically cross at the midpoint, thus there is no incentive for any trader to improve their order price to attract further liquidity.
In view of the foregoing, there is a need for new and improved systems and methods for trading trade lists or portfolios within ATSs while maintaining dollar neutrality and/or sector neutrality.